Canara Bank, the country's third largest bank, has set its sights on mid-sized Dena Bank and has appointed Ernst & Young to explore the possibility of the deal. This sets into motion the government's move to introduce consolidation among public sector banks.

Sources close to the development said the chairmen of both banks would meet shortly, after which the matter would be taken up by the respective boards and employees would be consulted.

Bangalore-based Canara Bank, which has a network of 2,542 branches, is strong in the south while Mumbai-based Dena Bank, with its 1,050 branches, has a large presence in Maharashtra, Gujarat and Chhattisgarh. It overtook Punjab National Bank in 2005-06 to become the country's second-largest public sector bank in terms of advances and deposits.

The government holds 73 per cent in Canara Bank and 52 per cent in Dena Bank -- the latter stake a little over the statutory cap of 51 per cent, which restricts the bank from raising further capital by diluting its stake.

The merger will help Dena Bank, which has just come out of a huge burden of sticky loans or non-performing assets. Though it is now better off financially, it has a limited capital base to grow business at the rates that the banking sector has seen in the last three years.

When contacted, Canara Bank chairman and managing director M B N Rao said he did not want to comment on the issue at this stage. Dena Bank could not be contacted.

Sources, however, said the merger would have to overcome several hurdles, including political ones. The much-talked about merger of Bank of India and Union Bank fell through because of the Left's pressure on the government over possible job losses.

PTI adds:

After the merger, the government holding in the new entity is likely to come down to about 65 per cent, depending on the swap ratio. The deal is most likely to be a cashless transaction.

The government is in favour of "voluntary" consolidation of state-run banks to create mega banking institutions to counter foreign competition.